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February 7, 2021, Christopher D. Carroll RandomWalk

The Random Walk Model of Consumption

This handout derives the Hall (1978) random walk proposition for consumption.
The consumption Euler equation when future consumption is uncertain takes the
form1
u0 (ct ) = βR Et [u0 (ct+1 )]. (1)
Suppose the utility function is quadratic:
u(c) = −(1/2)(c
− c)2 (2)
where c
is the “bliss point” level of consumption.2 Marginal utility is
u0 (c) = (c
− c) (3)
and suppose further that Rβ = 1 so that (1) becomes
(c
− ct ) = Et [(c
− ct+1 )]
(4)
Et [ct+1 ] = ct .
Defining the innovation to consumption as
t+1 = ct+1 − ct ,
(5)
≡ ∆ct+1 ,
the random walk proposition is simply that the expectation of consumption changes is
zero:
Et [∆ct+1 ] = 0. (6)
This means that no information known to the consumer when the consumption choice
ct was made can have any predictive power for how consumption will change between
period t and t + 1 (or for any date beyond t + 1).

References
Hall, Robert E. (1978): “Stochastic Implications of the Life-Cycle/Permanent
Income Hypothesis: Theory and Evidence,” Journal of Political Economy, 96, 971–87,
Available at http://www.stanford.edu/~rehall/Stochastic-JPE-Dec-1978.pdf.

1
See handout Envelope for the derivation of the Euler equation in the perfect foresight case; we
will show later that the consequence of uncertainty is simply to insert the expectations operator.
2
Assume that the consumer is sufficiently poor that it will be impossible for them ever to achieve
consumption as large as
c.